Via the excellent Damien Boey at Credit Suisse:
Bond and money market investors, as well as the Fed, have been keeping tabs on debt ceiling negotiations. Officially, the fear has been that if legislation were to not change, the US government would “run out of money” by September, causing shutdown and “default”.
The official narrative is of course quite misleading. The debt ceiling is a self-imposed constraint on the Treasury. Not only can it be lifted with the right political agreement – but even if it is not lifted, the Treasury can still spend without raising new debt. This is because the Treasury has access to back-door, “overdraft-like” spending facilities with the Fed. The Treasury has a reserve, or “general account” (TGA) with the Fed that it runs down whenever it spends. And when it does this, it creates several accounting entries in the system – deposits for the general public, held with the commercial banks, and excess reserves for the commercial banks (or exchange settlement account, ESA balances), held with the Fed. All other things being equal, the creation of excess reserves in the interbank system drops the Fed funds rate down to zero. But all other things are not equal. In the first place, the Treasury could issue bonds to the banks, to swap their excess reserves for longer duration, higher yielding securities. This called an open market, or sterilization operation. Secondly, the Fed could (and does) choose to offer interest on excess reserves to segment the Fed funds market, and give the Fed some control over a smaller segment of the market.
We highlight the plumbing, because it serves the additional purpose of showing that the Fed is not the only entity that can conduct quantitative easing. Quantitative easing is an asset swap between the Fed and the banks. The banks get excess reserves, and the Fed gets bonds in return. A virtually identical outcome is achieved whenever the US Treasury chooses to deficit spend without issuing bonds to sterilize the effects of their spending in the interbank market. And with the debt ceiling looming, the Treasury is forced into such a position. This has the effect of increasing interbank liquidity, putting downward pressure on interest rates at the short end of the curve. Perversely, the debt ceiling is actually positive for liquidity. And to the extent that liquidity matters for markets, it is supportive of risk appetite.
But the reverse is also true. Once the debt ceiling is lifted, the Treasury is empowered to issue bonds again to sterilize the effects of deficit spending on the interbank market. This represents a net drainage of liquidity, or “quantitative tightening”. It puts upward pressure on interest rates at the short end of the curve.
At present, the “front-end steepener” trade is still alive and well. The anticipated liquidity expansion from the US debt ceiling, combined with inversion of the yield curve and backwardation of the swaptions surface are all contributing to a bond market rally, led by the short end of the curve. Momentum chasers will read signal into these developments. And the Fed is enabling this behaviour by offering insurance rate cuts to appease the bond market. But fundamentally, the dynamics we are seeing are more temporary than permanent in nature. In our view, it is wrong to extrapolate a trend from the curve movements we are seeing.
Overnight, US President Trump suggested that a deal has been struck between the White House and top Democratic and Republican leaders in both chambers of Congress for a 2-year budget and debt ceiling, with no poison pills. If formalized soon, this will suspend the debt ceiling beyond the next election. In principle, the deal should phase out Treasury-led, stealth quantitative easing, and usher in a period of quantitative tightening. It should take off some of the downward pressure on the yield structure. But nonetheless, some investors will fear the effects of drying up liquidity on financial markets in a highly uncertain environment and still interpret the developments bearishly.
The bottom line for us is this – the Fed is on the cusp of a rate cut cycle. During easing cycles, yield curves tend to steepen. In this cycle, the long end of the curve is very overbought, if not outright expensive. It is susceptible to a sell off, especially if liquidity conditions were to dry up. The response function of equities to a bond sell off could be negative in the first instance, if investors believe that equities are simply too expensive relative to bonds. So quality exposures and bond proxies could lead an initial sell off, only to be bought back again as low-beta in a falling market. But it is a very big assumption to make that equities cannot strengthen in response to higher bond yields and curve steepening if:
- There is the promise of fiscal stimulus to compound the effects of monetary stimulus and support growth.
- Uncertainty levels in the world come off, partly because high uncertainty in itself provokes an easing response from policy makers.
Should we see the yield curve steepen, history suggests we should be looking to value factors to lead the way in equities. Interestingly, value factors are generally favouring higher beta stocks, and so the risk is that if equity markets weaken, that value will underperform quality. But history also tells us that value factors can do well into major equity market downturns and recessions. Correlation breaks are not only possible – but quite likely given the present concentration of positioning.